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Friday, August 24, 2007

Martin Wolf Drinks the 'Saving Glut' Kool-Aid

Martin Wolf is one of the best columnists in the financial press and I have always looked forward to reading his column in the Financial Times (FT). His columns bring fresh insight and reason to many of the big issues facing the world. So you can understand my utter shock when I opened Wednesday's FT and saw this title hanging over his column: Why the Federal Reserve has to Keep the Party Going.

After coming to from my initial state of shock, I sat down to read what Martin Wolf had to say. I was hoping his title was just some clever way to get readers attention, but alas it was not. Poor Martin Wolf apparently has had one-too-many drinks of the 'saving glut' kool-aid. It is one thing to argue for the 'saving glut' theory as a way to interpret the current global imbalances facing the world, but it is absurd to invoke it as a reason for the Federal Reserve to cut its policy rate to 'keep the party going'. His main point is that given the current global 'saving glut', the Federal Reserve must do its part to ensure that the U.S. economy, the demand engine of the world economy, keeps running. Consequently, to the extent the current financial crisis causes this important engine to sputter, the Federal Reserve should act aggressively.

There are several problems with his view. First, he ignores the 'liquidity glut' view of the current global imbalances that says at least some of the excess saving coming out of the periphery countries of the world has been due to the excessively accommodative monetary policy in United States. The story is that with U.S. monetary policy set on super easy between 2001 and 2005 and putting downward pressure on the dollar, these periphery countries who depend on a export-driven growth strategy for development had to buy massive amounts of foreign reserves to maintain both their peg to the dollar and their external competitiveness. Excess saving emerged as the result of these countries currency interventions--which again, were set off and driven by the loose monetary policy in the United States--that effectively increased the price and reduced the quantity of domestic consumption. Of course, the periphery countries could have chosen not to intervene in currency markets, but given that they did one clear implication is that the excess saving to some extent is a consequence of a policy choice made in Washington D.C. Asking the Federal Reserve to keep 'the party going' then is asking it to perpetuate it share of the global imbalances.

A second, related problem are the implications of his recommendation. As Catherine Mann notes in her response to this column, Martin Wolf essentially is prescribing more U.S. household indebtedness to maintain domestic demand and keep the global economy going. But is that not one of the very reasons we are in this financial quagmire now? Is not an overextended household sector one of the real economic distortions that has to be worked out? As Catherine Mann points out, "[i]t seems to me that continued unsustainable increases in household indebtedness should not be the outcome of Federal Reserve policy, no matter how important consumer spending is to the overall performance of the US economy." Why would we want more more asset bubbles and leverage when these very things put us where we are today.